Revenue growth vs margin growth 2 comments

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If one were faced with a choice between investing in a company that has been growing revenues phenomenally but with declining margins compared with another whose topline has been stagnating but exhibiting profit margin growth, and assuming the consequent bottomline growth for both has been similar, which would one choose? (Some smart aleck will say to choose one that shows both revenue and margin growth, of course.... whatever).

There are a few matters to consider and things need to be put into context in this issue. Firstly, for the former (revenue growth but compressing margins), has segmental contributions changed markedly? Sometimes margins shrink because the company's main business focus has changed; for example, Meiban, a plastics moulder, has grown its contract manufacturing division prodigiously over these two years such that this division now contributes more revenue than its plastics division, with the eventual shrinkage of margins since contract manufacturing is lower value-added than plastics moulding. Secondly, for the latter (stagnant revenue, rising margins), what is the nature of the industry and what is the margin growth due to? If it is a trading company, steel say, and its profit margin growth is due to rising steel prices then the margin growth would be less impressive than for a comsumer products company with adequate pricing power to raise prices and yet retain a loyal customer base. Also, if higher margins were due to cost cutting rather than rising customer acceptance, one has to question how sustainable this is.

My personal preference is for the latter: the stock with rising profit margins. The simple reason is that it is much easier to grow revenue than to grow margins. The former can easily be inflated by securing deals at unfavourable rates (eg. the Singapore construction industry), by accepting unfavourable credit terms that might turn into bad debts (Lucent and Cisco in 1999-2000), by aggressively investing in new production lines / capital equipment regardless of market supply/demand conditions (something the shipping industry is poised to face in 20067 when a plethora of new vessels come onstream). The latter (rising margins) is more difficult to achieve, because it entails customer perception of rising value-added by the company resulting in them being willing to pay a higher price for its services. That implies considerable barriers to entry, whether it is technology-based, relationship-based or branding-based.

Actually, the company with a rising topline might turn out to be the better long-term prospect, especially if its declining margins are mainly due to rising raw material costs. As long as it continues to grow its customer base, it will ultimately be recognised as the business cycle turns and as margins recover its profit growth could be spectacular. However, in the medium term it is operating against a headwind; the investor faces the difficulty of quantifying how much revenue is going to grow, the degree to which margin will fall, and ultimately how these two will interact towards eventual bottomline. That's quite a few unknowns, and hence risks, he has to monitor. For the other case, provided there is no erosion of topline, the investor knows that the company is operating with a strong tailwind and the only thing he has to focus on is monitoring the qualitative fundamentals of the industry to corroborate his views on its underlying strengths. As I consider myself a medium-term position investor, I tend to go more for the latter.